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Tales of the unexpected

This is an historical document which was correct at the time of publication. It is now out of date. It was most likely subject to different rules and regulators at the time it was in date.

The term ‘Goldilocks economy’ was coined in 1992 to describe the US economy which at the time was experiencing moderate economic growth and low inflation. In other words, it was neither too hot nor too cold, but “just right”. The Goldilocks era lasted a long time. At the end of 2007, after the advent of the credit crunch, prominent economist Nouriel Roubini took part in a heated televised debate over whether the term could still be used to describe the situation in the US. The following year, the Dow Jones Industrial Average lost nearly a third of its value as investors feared a repeat of the Great Depression of the 1930s. In recent months, the term has started to be used again as the US economy hums along at a pace that boosts living standards without generating inflation. Could it be that investors are becoming complacent once again following a long bull run in which the price of most assets has skyrocketed?
Have financial markets already forgotten the lessons of 2008?

Rate hike concerns

There are certainly plenty of reasons to worry about the outlook for the global economy and financial markets. They include the prospect of US interest rates – which have been kept at a record low of 0.25% since December 2008 – rising for the first time in nine years. A sizeable correction in the price of risk assets is possible when US monetary policy is eventually tightened.

A rate hike could have a particularly negative impact on emerging economies. Capital outflows may drive asset prices even lower and lead to currencies weakening even more against the US dollar. Few emerging economies would be immune, although China, India and Russia have historically been less sensitive to developments in US financial markets than other emerging countries.

Reasons to be fearful

Recent developments in Greece have also demonstrated that the problems facing the euro zone have yet to be fully resolved. They still represent a significant downside risk to the overall outlook for the global economy and financial markets. The fact that Greece came so close to leaving the euro zone highlighted the critical flaw in the single currency project, namely that monetary unions are inherently unstable without political union.

The economic transformation seen in China in recent years has been one of the most remarkable stories of our age. But suddenly growth seems to be cooling as the economy matures, which is starting to reverberate across the world. For example, we have seen the price of oil and other commodities plunge. This is hurting raw materials exporters from Australia - where metals account for a quarter of exports - to Zambia, where copper makes up more than half.

Clearly, there are a number of sources of concern for investors right now. Worryingly, there are few places to hide given that the price of assets such as bonds and equities have in recent years been far more correlated than was once the case. Historically, rising equity prices were associated with falling bond prices and vice versa. Stronger economic growth would boost corporate earnings and hence share prices, while causing interest rates to rise, thereby undermining the appeal of bonds. Thus, the risk of investing in equities could be offset to some degree by allocating part of a portfolio to government bonds.

The drugs don't work any more?

Today this relationship is no longer so clear cut. The aggressive monetary policy adopted by central banks around the world in response to the global financial crisis of 2008 has led to most asset prices surging in recent years. Consequently, there is less to be gained by investing in a mix of assets than in previous decades.

Consequently, the traditional approach of targeting equities for capital growth, bonds for income and as a safe haven in times of trouble, and alternatives for extra diversification, no longer appears as valid. Furthermore, it is difficult to rely on equities for long-term capital growth given that valuations look expensive on most long-term measures. Meanwhile, the income generated by bonds is very low. There are also doubts as to the amount of protection bonds will afford in the event of an equity market downturn given that prices are already so high.

Despite the unprecedented period of experimental, accommodative monetary policy undertaken by major central banks since 2008, economies have continued to grow at a fairly lacklustre pace. With this policy stimulus set to be unwound, there is a risk that neither economic growth nor interest rates return to historical averages for some time, if ever.

Time for change

We believe our outcome-oriented, multi-strategy funds offer an attractive option for investors in a world of low income and prospective returns. We aim to produce steady performance regardless of the investment climate. In other words our range of multi-strategy funds helps to protect investors against losing their capital. This is achieved by combining a wide range of strategies, some of which perform well when markets rise, and others when they fall. In an effort to improve risk-adjusted performance, we ensure our portfolios draw on a substantial pool of investment ideas. Outcome-oriented approaches can produce relatively smooth returns by carefully managing the risks to which portfolios are exposed. If risk is not accounted for on a forwardlooking basis, a portfolio may not be appropriately diversified. With bond yields so low and assets more correlated with each other than the norm before the financial crisis, what looks like a well-diversified portfolio may carry significant risk.

We believe our outcome oriented, multi-strategy funds offer an attractive option for investors in a world of low income and prospective returns.

Ian Pizer

Head of Investment Strategy

Risk-reduction measures

We have identified a range of strategies that aim to protect investors if financial markets sell off, and against potential sources of volatility. To offset potential losses should equities fall, for example, we have successfully deployed various strategies over the past year. Thus, ‘long’ positions on the US dollar and on Australian and South Korean government bonds cushioned the portfolio on those occasions when equities did decline. These strategies remain in place and should continue to provide protection against a downturn in equity markets.

The portfolio contains other strategies which are designed to protect it against the impact on equity markets of a hike in US interest rates. One of these entails being short US treasury bonds with two-year maturities. These ‘short-dated’ bonds are much more sensitive to changes in monetary policy than their ‘longdated’ counterparts. Thus, if and when the Federal Reserve does increase interest rates the shorter-dated bonds should fall much more sharply.

Another strategy is designed to benefit from any increase in the volatility of the Chinese renminbi’s exchange rate against the US dollar. The potential for currency volatility was highlighted in August when China surprised markets by allowing its currency to depreciate against the dollar. Critically, this position adds value whether the renminbi rises or falls. It is the volatility that is important.

Other positions also look to benefit from a pick-up in volatility. For example, we have a trade in place that will benefit if euro zone equities become more volatile. The aim is to protect the portfolio against any further problems in the euro zone. Many member states continue to face highly challenging economic conditions, not least very high levels of unemployment that could spark political unrest and/or the election of governments that wish to challenge the status quo. To date we have seen considerable movement in euro zone bond markets and in the euro but not in euro zone equities and we believe this situation could change should the currency bloc encounter further turbulence.

A happy ending

In conclusion, while it appears there are plenty of reasons to be concerned about the outlook for financial markets, our team of highly experienced investment experts have dealt with similar challenges before, and with the breadth and depth of our global resources are in a strong position to continue to do so. We believe outcome-oriented strategies that seek to deliver specific goals in line with investors’ needs, while at the same time providing protection against a surprise event on world markets, are a wise investment. Unlike Goldilocks, investors do not want to be asleep when the financial market bears return as some day they must!

We believe outcome-oriented strategies that seek to deliver specific goals in line with investors’ needs, while at the same time providing protection against a surprise event on world markets, are a wise investment.

Ian Pizer

Head of Investment Strategy

Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at 31 October 2015. Unless stated otherwise any opinions expressed are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.